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A CRASH COURSE ON CHINA’S YUAN

From the AxSA Staff

#AxSAKnowledge 

As a trade war looms between the United States and China, the news out of Beijing is particularly interesting. Officials with the People’s Bank of China acknowledged that they are considering a devaluation of the yuan (or the renminbi (RMB)), in an effort to stymie the impact of the Trump tariffs on their exports to the United States. The strategy is mystifying, and if it actually executed, it just might work for them.

 

To call China a trade giant is an understatement. It is actually a trade behemoth that manipulates masterfully (more on the latter point in a second), exporting over $2 trillion dollars in goods and services globally. Consumer, commercial, and industrial markets in the United States, of course, make up significant destinations for those exports. In fact, sticky geopolitics notwithstanding, the United States and China share a pretty robust trade relationship. In 2016, trade between the two countries totaled nearly $650 billion. And, yes, for that same year, China did benefit from a roughly $385 billion trade surplus, relative to the total value of goods and services exported to China from the U.S.

Part of what gives China its major advantage when it comes to trade is the low cost of production. Businesses look to a number of considerations when choosing where to manufacture their goods: a stable political and economic environment; access to capital markets; a viable infrastructure; a competent workforce; and reasonably low costs to doing business. To that end, China stepped up its game – and it did so quickly. In 1990, China produced less than 3% of world’s manufactured goods, but now its output is more than one quarter of that. Decision-makers have been drawn to China for all of the typical considerations – but, most importantly, because of the low costs. And this is so, despite China’s spotty record on human rights, its murky rule of law (if you can even call it that), and even its laxed enforcement of intellectual-property rights.
So how has China kept the costs of doing business there down so significantly? Well, we can answer that question in two unflattering words – currency manipulation.

The yuan, China’s currency, is pegged to a basket (or formula) of 13 major currencies, with the U.S. dollar now representing just under 25% of the weight of its basket. In order to remain an attract destination for the production of goods, the Chinese smartly realized that it had to keep, both, its currency from appreciating in value and its economy from freely heating up as a consequence of all of this new business.

 

The strategy that China uses to maintain some control is often referred to as the “impossible trinity”. No country can have free capital flows in its economy, a fixed exchange rate, and control of its monetary policy, at all times. China enforces strict capital controls in its economy. For example, citizens of China and ex-pats working there cannot freely exchange their yuan for any foreign currencies. And that is an important fact to remember when you think of the Chinese consumer, who is not spending much of the money that he has earned after working long hours in that demanding economy. (Even if you hear a lot of glamorous stories about young Chinese splurging on European cars or pricey flats, just know that it’s not everyone. In fact, the Gross Savings Rate as a percentage of China’s GDP is 50%, making the average Chinese household far, far more frugal than its American counterpart.) Consequently, as the people of China save more and more, that money gets invested into more projects (like real estate) and production capacity, even beyond what is necessary to meet domestic demand. In the beginning, much of that money went into building factories, and those factories exported their excess production to markets willing to receive cheaper goods, thus creating the types of trade surpluses that we now see with the United States and the European Union.

The trade surpluses also create another phenomenon – the rabid accumulation of foreign reserves. China should naturally be awash with money from foreign businesses and consumers, and under normal circumstances, that money should have help to fuel an sharp appreciation in the value of the yuan. But to manage this phenomenon, the China government has made a practice of stepping in. The People’s Bank of China routinely prints an ever-greater supplies of yuan to buy up the foreign reserves and control the exchange rate. Price controls and bank lending restrictions are commonly implemented as ways of governing growth in its domestic markets.
Up until the middle of this decade, China was the fastest-growing economy on the planet, with annual upticks in GDP of 10% or greater. But all of that money could not go into building new factories. After all, global markets were only so big, and Chinese officials knew that they could only allow the outcry against their trade dominance to get so loud. Hence, China followed its impossible, but seemingly successful, trinity with other forms of global activity. For example, in order to maintain its penchant for trade-led growth, China’s central bank dabbles in foreign currency markets daily, taking significant positions in currencies like the dollar, in order to keep those currencies higher in value to the yuan, and it follows up its intervention into those markets with the issuance of bonds, so as to prevent the domestic money supply from increasing too significantly. Those positions don’t just sit idle; China puts its foreign reserves to work. In the case of the dollar (the world’s reserve currency), China uses it when making oil or other commodity purchases in the Middle East or in other developing countries. It also uses those dollars to make substantial project investments around the world, like its audacious Belt & Road Initiative, which would be the largest inter-modal system spanning three continents, and it uses those dollars to routinely buy U.S. treasuries, which is, quite frankly, the most sensible way for China to hold most of its dollar reserves, now standing over $3 trillion, as of February, 2018.
China has proven itself masterful at a game that goes beyond simply shipping goods across oceans, and it would be reasonable for even the casual observer to believe that China does not plan to lose any trade war that President Trump has initiated. By devaluing the yuan – a readjustment of its peg to other currencies – China could essentially be giving exporters a subsidy that undermines the Trump tariffs, and in the process, it would do little to no damage to its own well-managed, domestic economy. Conversely, the same practice could not be used by the United States to usurp China’s retaliatory tariffs.
The best solution, at this point, is not to ratchet up tensions with talk of new tariffs. Indeed, barriers create more barriers, and once instituted, they will be difficult to bring down. No, this best solution is for the more pragmatic members of the Trump administration to work with the Chinese, if necessary, through quiet channels, in order to save face and resolve this matter. After all, no one wants a trade war that will only drain millions from the American middle class and put our two countries on an adversarial path. The reality is that United States and China, though some are reluctant to admit it, are interdependent on one another. It is time that we all begin to act like it.
(c) 2018, Axiom Strategy Advisors, LLC. All rights reserved.
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A TREP’S GUIDE TO SOURCING IN CHINA

With all of the talk about tariffs and trade wars, AxSA has been getting a lot of questions about what it’s like to manufacture products in China. The biggest one: Does China really cheat on intellectual property? And our answer is simple: Hell yeah, it does – and you are still going to do business there!

 

That is the reason we published this piece of wisdom four years ago.

 

January, 2014

Written By Gary C. Harrell

______________________________

 

It is not uncommon for entrepreneurs to fear the idea of sourcing their products abroad, particularly to suppliers in a country like China, a place where the shanzhai culture of counterfeiting goods can be such a pervasive practice. Nevertheless, China still ranks among the world’s leading destinations for outsourcing. In spite of the risks, producers are still attracted to China because of its high technical prowess and relatively low costs. So are the fears warranted, or is what we are hearing simply overblown? Well, there is no discounting that the theft of intellectual property is a real risk in a country like China, but the fears of such risks may, in some cases, be misdirected.

 

In speaking with entrepreneurs, one thing this consultancy has found is that many are most afraid of the prospects that their own suppliers will be the culprits behind counterfeiting their goods. That is a real possibility, but we believe there are a few rules that entrepreneurs can follow to reduce the risk of this happening.

 

Select a reputable sourcing agent. 

Many businesses, and particularly most small entrepreneurs, lack the knowledge to circumnavigate the business environments of foreign countries. Consequently, they may hire third-party sourcing agents to facilitate relationships with suppliers. This can be a useful entrée into those foreign countries, where differences in language, culture, and infrastructure may pose challenges. That said, though, entrepreneurs would be well-served to keep in mind some key points when selecting their sourcing agent:

  • The sourcing agent must have real familiarity with the local business terrain, and he should also maintain an on-the-ground presence in that market.
  • The sourcing agent should have a strong track record as a liaison, providing the entrepreneur with a fair number of references.
  • The sourcing agent should report to the entrepreneur, in writing, on a regular basis, even if nothing new or unexpected is occurring.
  • The sourcing agent is not a permanent fix. No business should foster an indefinite reliance on a third-party agency without cultivating its own direct channels for communications and accountability with its supplier.
  • The sourcing agent needs to work for the entrepreneur, not the supplier. No exceptions.

 

Identify a reliable supplier.

Once the entrepreneur and the sourcing agent are ready to do so, the vetting and selection of a supplier really is no different from the way it is done domestically. The entrepreneur should verify that the supplier has the competency needed to build the products being sourced, the capacity to meet the requisite needs, and the ability to scale that capacity up when demand increases. Accessibility should also be a concern for the entrepreneur; a lack of critical infrastructure near the supplier can hinder both communications and transportations, thereby adding to logistics costs. And, of course, the entrepreneur will need to confer with references provided by the supplier, to evaluate the supplier’s track record on, among other things, quality, timely deliveries, services, communications, and ethical business practices.

 

Lawyer up—and document everything!

“Shanzhai” is a Cantonese word used to refer to the inferior knock-offs of well-known products being churned out of some Chinese factories. As more and more outsourcing came to China at the end of the last century, the number of knock-offs exploded. Today, the shanzhai culture is so pervasive—and, unfortunately, so much more improved—that counterfeiting in China is estimated to cost businesses nearly $20 billion in potential revenue.

 

For small entrepreneurs new to the sourcing world, this can be disconcerting. And while there may never be a way to completely head off the risk of counterfeiting, having product designs properly patented and trademarked, alongside working with legal counsel to draft comprehensive manufacturing agreements that conform to both domestic and foreign rules of law, promises to be the best way to reduce such risks. A well-drafted series of contracts between the entrepreneur and the supplier (as well as any subcontractors, if necessary) should help to make clear the terms and expectations in this new relationship. In addition to a number of other components, a good manufacturing agreement should specify, in detail, the following:

  • Product specifications
  • Product standards
  • Procedure for manufacturing
  • Identification and descriptions of any subcontracted parties
  • Payment schedules
  • Deliveries
  • Warranties
  • Site inspections
  • Framework for legal recourse
  • Acknowledgement of intellectual property rights
  • Confidentiality and non-use agreements
  • Exclusions
  • Shipping specifications (with details about performance, control of goods, insurability, etc.)

 

If the supplier has a reasonable reputation for being above-board, then there is probably little reason for immediate concern that this partner will be the culprit of any counterfeiting. In fact, the problem, more than likely, may originate with manufacturers with whom the entrepreneur has no contact and, consequently, no working agreements. These unconnected manufacturers are notorious for reverse-engineering products, sometimes at the behest of an entrepreneur’s competitor, and mass producing replicas of, or developing slightly different versions of, the entrepreneur’s product. To this end, the entrepreneur would be well-served to use resources in the foreign market, like those provided by some larger sourcing agencies, to monitor the foreign marketplace and identify incidents of counterfeiting.

 

Conduct on-site inspections and establish communications channels.

An entrepreneur cannot rely too heavily on the efforts of the sourcing agent. He must travel to the supplier to assess the operations. These site inspections not only bolster the entrepreneur’s familiarity of the manufacturing process, they provide him with a great way to build a direct rapport with the supplier. The goal is not to completely usurp the inroads forged by the sourcing agent, who should continue to work as a tactical representative of the entrepreneur, but the direct channels of communication can be useful when unforeseen issues arise.

 

Understand the role of the foreign government and the legal landscape.

To simply say that an entrepreneur should have ready and competent legal counsel at his disposal is a glaring understatement. Many foreign countries—and China, particularly—can be a litigious minefield for even the savviest businessperson, and for a small entrepreneur, legal challenges in these markets could overwhelmed their personal savings and the finances of his new business. Therefore, it is quite imperative for an entrepreneur to retain legal counsel with a broad wingspan of resources in the market in question. He should also attempt to learn, in advance, as much as he can about the legal terrain of the foreign country, so as to fully understand where, if any, potential liability exposure may reside.

 

What’s more, it is important to have a clear picture of how intellectual-property rights are protected in the foreign country. China poses an interesting case, inasmuch as its overall handling of the shanzhai phenomenon has been spotty, yet foreign firms have still elected to outsource to this country. The proper treatment of intellectual property had not always been a matter of serious interest in this country. In fact, it was not until 1992 that the Chinese entered into a Memorandum of Understanding with the United States, wherein China agreed to acknowledge the trademarks and patents of companies filed in the U.S., and in doing so, agreed to provide similar protections against the infringement of those works within its borders. That language was largely codified into law in 1996 with the signing of the Sino-U.S. Agreement on Intellectual Property Rights. Suffice it to say, though, the law did little to reduce infringements, and the intellectual-property arena remains as murky and troublesome as ever in China.

 

Part of the problem in China exists in its patent framework, while another part of the problem is owing to the manner in which culture and biases trump the rule of law.  First, China splits its patents into three significant types: invention patents (which, until recently, were only available for product made and originally made in China); utility model patents (which protect the shape, structure, and composition of a good for a period of ten years); and design patents (which, of course, only protect designs). In order to enforce these patents, officials in China deploy a “double-track” system that allows an aggrieved party to challenge an infringement through administrative channels or a judicial course of action via the courts. While the administrative approach may seem less costly, it can be tremendously time-consuming with no assurance of resolution. Meanwhile, costs notwithstanding, the courts pose their own hurdles. In 2004, the number of patent lawsuits filed in Chinese courts stood at just over 2000, but by the end of 2008, that number rose to 8000, creating a backlog of cases threatening to overwhelm an already-burdened system. Complimenting this, though, is a problem deeply rooted in xenophobia. Judges have shown suspicious deference for local companies, and since many of these judges do not consistently write or publish their rulings, it is often impossible to determine the motivations behind their decisions.

 

For all of these reasons and others, an entrepreneur should follow the lead of larger businesses, who elect to fight infringement cases, when or if the opportunities ever present themselves, in the United States or other countries with more transparent courts and histories of upholding the rule-of-law, rather than places like China.

 

The outsourcing of goods can, of course, saves many businesses significantly on production costs, while increasing the margins on those businesses’ products. This fact has proven itself true for companies as large as General Motors in Detroit and as small as an industrial clamp maker in South Texas. But what is also true is that both businesses face the risk of losing their intellectual property to the shadowy side of manufacturing in a place like China, where counterfeiting has become a lucrative business. For this reason, like their larger counterpart, small entrepreneurs must do everything they can to protect their intellectual property. The high points shared in this missive are a good first step in that process.

 

© 2014 All rights reserved; Axiom Strategy Advisors, LLC

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